Understanding Operating Profit, Capacity, and Inventory Costing
Obtaining accurate data on operating profits is vital to sustaining and building a business organization. Operating profit figures inform decision-makers about the resources they can use to achieve their organization’s objectives. In business, capacity is generally understood to mean a ‘constraint’ and the ‘upper limit’ at which a company can operate. But this refers to the capacity level required to generate an acceptable profit margin. It does not mean that capacity is limited to a particular rate. Rather, the fact that we can manage capacity tells us that the decisions and actions of an organization can re-determine this upper limit.
Capacity Levels
There are four capacity levels used as the denominator to compute the budgeted fixed manufacturing cost rate:
- Theoretical capacity: is the level based on producing at full efficiency all of the time. 25 units per shift X 2 shifts per day X 360 days = 18,000 units
- Practical capacity: is the level of capacity that reduces theoretical capacity by recognizing unavoidable operating interruptions such as scheduled maintenance time, shutdowns for holidays, and so on. 20 units per shift x 2 shifts per day x 300 days = 12,000 units
Both theoretical capacity and practical capacity measure capacity in terms of what a plant can supply – available capacity. In comparison, normal capacity utilization and master-budget capacity utilization measure capacity levels in terms of demand for the output of the plant – the amount of available capacity that the company expects to use based on demand for its products.
- Normal capacity utilization: is the level of capacity utilization that satisfies average customer demand over a period of, say, two or three years, which includes seasonal, cyclical, and trend factors.
- Master-budget capacity utilization: is the level of capacity utilization that companies expect for the current budget period, which is typically one year.
Which Denominator-Level Concept Is the Most Reliable?
Because practical capacity measures the available supply of capacity, decision-makers can use engineering studies and human-resources considerations to obtain a reasonable estimate of the denominator level for the budget period.
Inventory Costing and Performance Measures
There are two main types of inventory-costing methods: variable costing and absorption costing (also known as full costing).
- Variable costing is a method of inventory costing in which all variable manufacturing costs (direct and indirect) are treated as inventoriable costs. All fixed manufacturing costs are excluded from inventoriable costs and are instead treated as costs of the period in which they were incurred. The term variable costing is somewhat misleading, as not all variable costs are inventoriable, only manufacturing costs.
- Absorption costing is a method of inventory costing in which all variable manufacturing and fixed manufacturing costs are included as inventoriable costs. That is, the inventory absorbs all manufacturing costs.
In both variable and absorption costing, all nonmanufacturing costs in the value chain, whether variable or fixed, are period costs and are recorded as expenses when incurred.
Activity-Based Costing (ABC)
The ABC system enables companies to track how their different products consume resources in different ways by allocating indirect costs of activities. It establishes a more complex and deeper relation between cost object and driver. It leads to more accurate product costs.
Budgeted overhead rate: Budgeted Direct Materials/Budgeted overhead cost.
To Implement ABC:
- Significant overhead cost allocated using 1/2 cost pools.
- Most overhead is considered unit-level.
- Products that consume different amounts of resources.
- Products that work well, show small profits.
- Operations staff differ with accounting (health care, banking, telecommunications).